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Is Colgate-Palmolive's Share Buyback Program the Best Use of Capital?

Colgate-Palmolive spends more on share buybacks than it does on dividends. This is a questionable policy, because of its lower dividend yield than many of its competitors, and a paltry dividend increase this year.

Consumer staples giant Colgate-Palmolive (NYSE:CL) is one of the most highly regarded stocks in the realm of shareholder returns. But that's likely because of Colgate-Palmolive's dividend track record. What you might not know is that this company is also aggressively buying back stock, and using a lot of cash to do it. In fact, Colgate-Palmolive's billion-dollar buyback program might raise questions about its cash allocation priorities.

That's because Colgate-Palmolive offered up a dividend increase earlier this year that could easily have been viewed as a disappointment. And underlying earnings growth through the first several months of 2014 has been less than impressive, so it's reasonable to wonder if some of its cash flow could be better used being reinvested in the business. With all this in mind, let's dig deeper into Colgate-Palmolive's share buyback program to see whether there's a better use for the company's capital.

Is Colgate-Palmolive under-serving dividend investors?Colgate-Palmolive has several well-known brands with leadership positions in their respective industries. A few of these include its flagship Colgate toothpaste and Palmolive dish soap, along with hand soap brands Irish Spring and Softsoap. Colgate-Palmolive also operates a pet nutrition business, led by the Science Diet brand.

Growth so far this year has been solid. On the surface, Colgate-Palmolive's sales growth looks tepid. It's put up flat sales over the first half of its current fiscal year. Organic sales, however, which strip out currency fluctuations, increased a more satisfactory 6.5% in the first quarter and 4% in the second quarter, both on a year-over-year perspective. This was due primarily to volume growth and pricing increases, which demonstrate the brand power Colgate-Palmolive enjoys.

Colgate-Palmolive aggressively buys back its own shares. The company spent $746 million on share buybacks over the first half of the year, which helped reduce its diluted share count by nearly 2% over this time. Colgate-Palmolive's share buybacks were 12% greater than the $662 million of dividends it paid during this period.

A greater dividend increase may be more valuable than buybacksMeanwhile, those who hold Colgate-Palmolive shares primarily for the dividend might be feeling short-changed. That's because Colgate-Palmolive has a long track record of strong dividend increases, which means investors probably expect stronger dividend raises than the company delivered this year. For example, consider that Colgate-Palmolive has paid uninterrupted dividends since 1895. And in the five-year period leading up to its most recent dividend increase, the stock's compound annual dividend growth rate was 11%.

However, Colgate-Palmolive's 2014 dividend raise was just 6%. Even including this, Colgate-Palmolive stock yields just 2.2%, which is barely on par with the S&P 500 Index. Colgate-Palmolive's yield is also well below that of competitors Procter & Gamble and Clorox, which both sport yields in excess of 3%. That means that there was definitely room for a bigger dividend increase.

Another reason Colgate-Palmolive could have been better serving its investors by providing a higher dividend increase this year is because the stock is fairly aggressively valued. Shares of Colgate-Palmolive trade for 27 times trailing earnings per share and 20 times forward EPS estimates. This matters from a share buyback perspective because at such lofty valuation multiples, the company's share buybacks accomplish less in creating value for shareholders. Buybacks are best utilized when a stock's valuation is low. That allows the company to buy more shares with every dollar spent on repurchases, helping to further boost EPS than when the stock is high.

The Foolish conclusionColgate-Palmolive has had a successful start to 2014. Organic sales growth has been satisfactory, and management expects a good year overall. The company generates plenty of cash flow, which it uses both to buy back its own shares as well as pay a dividend to shareholders.

Colgate-Palmolive may create more value for investors by utilizing more cash flow to help raise its dividend at higher rates. Colgate-Palmolive spends more on buybacks than it does on dividends. The stock offers a lower dividend yield than many of its competitors in the consumer staples sector. And with a premium valuation that is blunting the impacts of its buyback program, Colgate-Palmolive should spend more on dividends and less on share repurchases.

Author

Bob Ciura, MBA, has written for The Motley Fool since 2012. I focus on energy, consumer goods, and technology. I look for growth at a reasonable price, with a particular fondness for market-beating dividend yields.